Preparing for the Unthinkable: Could Markets Handle a US Default?

Thursday, 17 Jan 2013 | 7:37 PM ETReuters

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Squabbling in Washington over the debt ceiling is again raising the specter that the United States may be forced to delay payments on its debt. While the stigma of a default would be damaging enough to investor sentiment, the chaos from a breakdown in financial markets' systems that might result would be even scarier.

A failure to make payments on U.S. Treasuries, however brief, would create widespread damage in short-term funding markets, which are crucial to daily operations of financial institutions, investment firms and many corporations, said analysts and investors.

In the event of a default, confusion would be rampant as trading systems struggle to identify, transfer and settle bonds that have matured but have not been repaid. Interest rates would surge and investors would likely sell stocks and commodities as they fled risky assets, analysts said.

But that doesn't mean investors would necessarily run to the safety of Treasuries. Many U.S. government bonds could be shunned as investors worry about which issues are in default - even longer-dated issues that could have a coupon payment due that would potentially be in jeopardy.

A default could also trigger a wider paralysis in the financial system that could quite quickly stall the economy, as happened at the height of the financial crisis in September 2008.

For starters, money market funds are not allowed to hold defaulted collateral. These funds pulled back on making loans in 2011, when the ceiling was last an issue, and some analysts fear this time could be worse, potentially creating broad funding problems and send the cost of borrowing in short-term markets, including those in repurchase agreements or loans based on Libor - surging.

The U.S. Treasury hit its $16.4 trillion debt ceiling - the legal amount it is allowed to borrow - on New Year's Eve. The Treasury Department will run short of funds as early as mid-February, so legislation is needed to increase the borrowing limit. This had been a formality for years but turned into a political standoff between congressional Republicans and the White House over government spending levels in the summer of 2011. The resulting battle roiled markets concerned about U.S. political gridlock and its impact on the economy.

The likelihood of a default on U.S. Treasuries has in the past been seen as so low that many parts of the market fail to even account for it in planning and paperwork. For example, unlike other debt, such as corporate bonds, Treasuries documentation has no grace period to make up for missed interest or principal payments.

Many banks and investors may not even have the systems needed to screen out which Treasuries have principal or interest payments due that are most at risk of not being paid.

"No one is going to build a system to assume you have a defaulted Treasury floating around there; it's not a baseline assumption," said Michael Cloherty, head of U.S. interest rate strategy at RBC Capital Markets in New York.

Treasury bills maturing at the end of February and in March are most vulnerable to default, though analysts said hundreds of other issues also have coupon payments due at the end of February. Rates on some short-term debt maturing in that time have risen and now yield more than similar debt maturing in April, a sign that a dislocation has started.

Interconnection and Contagion

The chain reaction from a potential default suggests a slow spread of damage through various parts of the banking system, particularly the $5 trillion repurchase agreement market, which many companies rely on for funds.

The Treasury Market Practices Group (TMPG), a group of market participants, has been looking into operational challenges of a U.S. default since the 2011 fight. It noted that other major events such as a terrorist attack, a failure of trading or other operational systems, or a natural disaster could also delay a debt payment.

One potential problem is that the New York Fed's Fedwire Securities Service, which is used to hold, transfer and settle Treasuries, would need some manual daily adjustments, as it otherwise can't transfer bonds that are past their maturity date, the group said in meeting minutes from last year. Other systems may have similar problems, it said.

Treasuries are widely used to back loans in the repo, or repurchase agreement, market, and in privately traded derivatives and for a host of securities traded on exchanges. Ownership and possession of the bonds is transferred regularly as part of this collateralization process.

But put sand in the gears of the transfers, and anarchy may ensue.

After the September 2001 attacks on the World Trade Center and the Pentagon, market participants struggled to identify who their counterparties were in the repo market, and even had difficulty grasping whether their net Treasuries position was a long or short one, after trading records were destroyed.

The number of trade "fails," when the borrower doesn't supply Treasuries to settle a loan, surged in the weeks after the attacks, initially rising because of operational problems and then staying high as the cost of obtaining Treasuries to settle a loan was as expensive as the cost of allowing a fail.

To resolve the issue, the Treasury held a special auction of 10-year notes to increase supply and help settle the loans.

The U.S. has defaulted once before, in 1979, when lawmakers were blamed in part for allowing negotiations to go down to the wire before raising the debt ceiling.

After that, back-office errors at the Treasury, caused the government to be late in redeeming three series of Treasuries bills, according to an academic paper by Terry Zivney and Richard Marcus published in the Financial Review in 1989. The failure caused rates to rise, and the government faced lawsuits from investors hurt by the delays in repaying the bonds, they said.

Markets now are far more complicated. Battles over ownership, interest paid or owed and a host of other issues relating to the transfer of the securities would likely be mired in legal disputes. U.S. debt is also considerably higher, and there is greater foreign ownership of Treasuries. The economy is also more vulnerable, making the risk of a creditor exodus a far more damaging prospect for the country.

"The minute we default, there would be a complete collapse in the bond market," said Peter Schiff, chief executive officer of Euro Pacific Capital and a critic of U.S. government spending habits.

That would leave the U.S. struggling to refinance more than $4.6 trillion that come due within two years, including $3 trillion of Treasuries due to mature in 2013.